New Research: Determining the Optimal Capital Requirement

New Research: Determining the Optimal Capital Requirement

We’ve made our support for higher capital requirements no secret on Rent Check. But just how high should capital requirements be is an open question. Our financial system as it exists today is far too reliant on debt financing, even though most banks are above the regulatory minimum of 4 percent.

The danger posed by another financial crisis is clear, but opponents of higher capital requirements argue that greater reliance on equity financing is more expensive for banks and could lead to a sub-optimal amount of lending, hurting the “real economy.”

This study reports estimates of the marginal benefits and costs of increasing the regulatory minimum bank equity-to-asset “leverage ratio” from 4 to 15 percent. Benefits arise from reducing the probability of a banking crisis. Costs arise from reduced lending, should banks pass off higher equity costs onto borrowers. Net benefits increase with a higher discount rate, a smaller tax advantage of debt, a lower non-financial corporate debt-to-capital ratio, a higher cost of crises, a longer duration of crises or if crises have some permanent effects. Baseline estimates indicate that the benefits equal costs at 19 percent.

This 19% figure is a conservative (low-benefit, high-costs) estimate, however. When using different assumptions, such as a higher discount rate, removing the preferential tax treatment of debt, and the long-run spillover effects of financial crises (called “temporary effects”), they find that costs equal benefits at higher required levels of equity financing.

Across all assumptions used, the optimal capital requirements calculated are in the 20 to 30%, within the range of what the Minneapolis Plan and Niskanen advisory board member Anat Admati recommend. But, while their baseline figure is 19%, using assumptions that reduce the economic costs of capital requirements, they find the optimal requirement to be equal to 25%, rising to 34% using the lowest-cost assumptions used by other studies.

The authors also find that the lower (higher) the capital requirement (leverage ratio), the greater the decrease in the odds of a banking crisis from increasing the capital requirements, indicating diminishing marginal returns as the requirements increase.

From the paper, it’s clear to see that there are a great many variables at play when determining the optimal level of equity financing. What’s even more clear, however, is that we’re a long way off from this optimum.